An article in Forbes magazine alleges that the Employees’ Retirement System of Rhode Island paid kickbacks to placement agents. As most are aware, the Employee Retirement Income Security Act of 1974 (ERISA) does not apply to governmental plans. So, what kinds of protections are available in the case of kickbacks from public retirement systems?
Federal Securities Law
One alternative is mentioned in the article. In some instances, the SEC has required money managers utilizing “secret agents†as marketers to offer public pension investors return of principal invested plus all fees paid. However, this alternative penalizes only those who received kickbacks, not those who agreed to pay them.
Federal Tax Law
Federal tax law contains two restrictions on kickbacks by a qualified retirement plan:
- Under Internal Revenue Code (Code) section 401(a)(2), a plan can be qualified only if:
it is impossible, at any time prior to the satisfaction of all liabilities with respect to employees and their beneficiaries under the trust, for any part of the corpus or income to be (within the taxable year or thereafter) used for, or diverted to, purposes other than for the exclusive benefit of his employees or their beneficiaries…
- Under Code section 503(a)(1)(B), a governmental plan will cease to be exempt from tax under section 501(a) if it engages in certain “prohibited transactions.” Under Code section 503(b)(2), paying “any compensation, in excess of a reasonable allowance for salaries or other compensation for personal services actually rendered,” to certain parties related to the trust is a prohibited transaction.
With regard to section 503(b), an initial hurdle would be showing that the persons receiving kickbacks were parties related to the trust. A more serious difficulty with using federal tax law in these circumstances is that it may impose a penalty on the very employees who were hurt by the original kickbacks. In the case of a private employer, disqualification of a retirement plan harms the employer (because it loses tax deductions for contributions to the plan trust), the trust itself (because it becomes taxable), and the employees (because they become taxable on vested contributions to the trust, and lose the ability to roll over distributions from the trust). However, the first two of these issues do not apply to public retirement systems. The employer (being nontaxable) is not concerned about deductions. Under News Release IR-1869 (August 10, 1977), a plan that ceases to be qualified or otherwise loses its tax-exempt status under section 501(a) is nevertheless tax-exempt due to its governmental status. Thus, the only adverse consequences of disqualification/loss of 501(a) status fall on the employees.
State Law
In general, state laws provide the greatest protections for employees, and the greatest possibility of sanctions for fiduciaries. They act in two ways:
- Governmental entities are typically responsible for ensuring that promised pensions are paid, regardless of sufficient assets are available in the pension plan to pay them. This contrasts with the situation of corporate pension funds, in which the employer’s liability for previously promised pension costs may be limited if:
- the employer is facing liquidation under bankruptcy proceedings,
- the costs of continuing the plan will cause the business to fail, or
- the costs of continuing the plan have become unreasonably burdensome solely because of a decline in the employer’s workforce.
- State fiduciary laws may impose liability on fiduciaries for misconduct. Where available, this provides one of the few mechanisms for directly imposing liability on those responsible for the situation.